Introduction to Asset Allocation

The concept of asset allocation was one of the first concepts I studied on my road to fiscal fitness. Asset allocation is the practice of dividing an investment portfolio among different asset categories.

This concept can support another well know investing concept, diversification, spreading your money among various investments in the hope that if one investment loses money, the other investments will make up for those losses. Many investors use asset allocation as a way to diversify their investments between the asset categories. However, some investors purposely choose an investment allocation that is not diversified.

A young investor might go 100% in stocks, 0% in cash and 0% in bonds. This allocation could be viewed as a proper asset allocation because they are willing to assume a high level of risk and have a long time to reach their goal. Therefore, choosing an asset allocation model does not necessarily diversify a portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments. To be well diversified, investments should be spread between and within the different asset categories.

The most common asset categories are cash, bonds, and stocks. Cash and cash equivalents (e.g. savings deposits, certificates of deposit [CD], treasury bills, money market funds, and money market accounts) are the safest investments as the federal government guarantees many of the investments in this category. However, they generally offer the lowest return of the three major asset categories and a concern for SavvyInvestors is that inflation will outpace the rate of return and erode the cash asset value over time.

In the middle of the spectrum you have bonds. They generally offer better returns than cash and cash equivalents, yet lower returns than stocks. For many investors, holding bonds is an attractive alternative to leaving the investment portfolio at greater risk if too heavily weighted toward stocks. Investopedia provides a good basic tutorial on the different types of bonds.

On the other end of the spectrum from cash is stocks. Stocks, also referred to as equities, represent a share of a company held by an individual or a group. This asset category has historically had the greatest volatility, greatest risk, and highest returns among the three major asset categories. Their appeal is that they offer investors the greatest potential for growth. Mutual funds, made up of a collection of stocks, bonds, and other securities would also be grouped into this asset category.

The mix of cash, bonds, and stocks that you hold in your portfolio at any given time is very personal and will change over time. The allocation of your assets is not a case of doing it once and being done; it is not a static practice.

The asset allocation that works best for you at any given point in your life will depend largely on numerous factors such as your tolerance for volatility and risk, your time horizon, and your goals.

SavvyInvestors understand that the reward for taking on more risk is that there is a potential for a greater return on investments. Generally speaking, the longer the time horizon, the more likely investors will make more money by thoughtfully investing in asset categories (e.g. stocks and bonds) with greater risk, vice limiting investments to assets with less risk – and less return – like cash and cash equivalents.

A common practice among investors is to increase their cash and bond holdings, relative to their stock holdings (providing greater protection to their nest-egg), as they approach their investment goal, retirement in many cases, and prepare to start the withdrawal process.

And you SavvyReader. What is your asset allocation? How is your portfolio balanced?

17 Comments

Michelle, I would encourage you to start investing right away. When you note that, “I would love to start investing,” I take that to mean that the money you have saved is sitting in low yield (e.g. checking & savings) accounts. As I have discussed in detail on this blog – here & here – I don’t believe people can afford not to be in the market, not to be investing.

There is no simple answer to the question, “where should I start?” There a number of factors – time horizon, tolerance for risk, competing interests (e.g. college for kids, retirement, etc.) for your money and objectives – that will play into that decision. Considering it is my primary financial focus, as well as the focus of this blog, I approach the question with retirement as my primary objective.

I recently wrote a blog post about a cousin who approached me about some guidance for starting investing later in life. You can read it here. The suggestions I provided to her could be applied by anyone, particularly if they are starting late or are not sure how/where to start. As I touch on in my book, I don’t believe anyone has to invest in a number of different products, follow the market on a daily basis, or become some investing expert to have success. Consistently making contributions to a few well selected investments over a given time period (15, 20, 25 years) will serve most people quite well.

If I was starting today, with no existing investments, I would first look to contribute to a defined contribution plan (e.g. 401k) if available with my employer. If not, I would open a Roth IRA account. In either account, I would choose a simple life-cycle (aka target date) fund. I would do that immediately! Tomorrow morning at the latest.

With a retirement account open, I would start evaluating the factors noted previously (e.g. tolerance for risk) and start educating myself on the different investment vehicles/products (e.g. stocks, bonds,mutual funds, ETFs, etc.) and their pros/cons. Over time, I would develop a retirement plan based how those factors apply to my unique situation and on my understanding of the various products and how they might best work for me.

60/40 overall, 65/35 in our tax-sheltered investments. I use our taxable accounts to bring the overall allocation down to 60/40.

Only take as much risk as you have to.

Keeping your expense ratios and costs very low is the other added factor. So many investors are paying 1%, 1.5% or 2% to their advisors and mutual fund companies. These costs have a huge long term impact. More than the difference between an 80/20 and a 60/40 portfolio.

That sounds like a pretty good mix. The wife and I are a little older and our allocation is slightly more aggressive. We will have a number of passive sources, therefore, that lets me be a little more aggressive.

“Keeping your expense ratios and costs very low is the other added factor.” Absolutely. Couldn’t agree more. That is something I touch on regularly on this blog, and specifically in the Avoid High Fees post.

Nice overview here! It’s certainly critical to understand asset allocation as well as to make sure that your investments within your asset buckets are well diversified, or spread out. Asset allocation is a dynamic concept and should change over time as an investor’s age advances and as risk tolerance changes.

Absolutely. My current asset allocation gives me pretty good diversification and right now, I’m just on a glide path for another 9 years, 3-4 years before retirement. At that point, I will probably raise the cash allocation to a more significant level.

There is a new school of thought out there that says while you should move to more cash and bonds as you approach – and in the first few years of retirement – you should start to increase the stock allocation after a few years in retirement. The method is covered in some detail in this article.

“Roughly 90/10 unless you include a pension as a portfolio asset. Then it’s closer to 50/50. How often do you rebalance?﻿”

My response…

“I have gone to more bonds/cash recently as I believe the next few months will be rough for equities. Right now I’m at about a 65/25/10 mix.

For me, I give a hard look to diversifying within asset classes semi-annually. Again, I typically maintain a pretty aggressive portfolio — say something on the order of 80-90/5-10/5-10 — between asset classes.”

Absolutely, Leona. I like to stress to people that it is not something that is done once and forgotten. It truly is an ongoing process that needs to be monitored, reevaluated, and adjusted as necessary; and as you note, differnet mixes can produce different – dramatically sometimes – results.

Great post James. I definitely think that asset allocation is one of the most important concepts in investing. I invest in the Target funds in Vanguard where the bond portion of the portfolio increases and reduces risk as I get closer to retirement age. I think it’s a good choice as it will re-balance on its own…

Great to hear from you, Andrew. The wife and I use the life-cycle (target-date) funds in our Fidelity IRAs. I appreciate not only the automatic re-balancing, but also the low cost which is an attractive feature. As you know, fees can be a killer as they negatively impact the power of time and compound interest.

Thanks for the post, James. I realise that this may be a bit off this particular topic, but you often hear investors like Warren Buffett saying that the conventional viewpoint of bonds being safer than equities is wrong. And especially in the light of the Eurozone crisis, there seems to be some truth to that. Do you have any thoughts?

Thanks for dropping by, Jayson. Warren who? Just kidding. I believe bonds being safer than stocks (equities) has become the conventional thinking because historically, they have proven safer – particularly when considering U.S. government bonds vice municipal bonds, or as you note, bonds issued by countries caught up in the Eurozone crisis. From that perspective Buffet is correct (for the record, I strive not to disagree with Mr. Buffett) as anyone that was/is holding certain Eurozone bonds will attest to. I believe the bottom line for SavvyInvestors is that while they should become familiar with certain principals, they have to recognize that many are largely general in nature and just a starting point. We all have to be careful not to become completely wedded to one idea and hang onto it forever regardless of new facts and/or information. Paraphrasing Alec Baldwin from Glengarry Glen Ross, Always Be Learning.

Hey SavvyJames, great post here. Asset allocation and diversification is incredibly important. I think we all just about understand that with greater risk comes greater reward but, who wants to take greater risks when it comes to retirement? I guess it’s only those who really want to make their investments work for them. Anyway, thanks for the great post!

Josh, Thanks for stopping by and taking the time to leave a comment. There is no doubt that understanding the concepts of diversification and asset allocation, and how they fit into an overall retirement plan, are incredibly important. As I slide ever closer to retirement, I make every effort to ensure that my portfolio reflects my tolerance for risk & volatility, and the amount of time left before I depart the work force.